Essentials of Economics

An Asia-Pacific Perspective, 4th edition

Chapter 6
Technology, Production, and Costs
 • Define technology and give examples of
technological change.
• Distinguish between the economic short
run and the economic long run.
• Understand the relationship between the
marginal product of labour and the
average product of labour.
Learning • Explain and illustrate the relationship
between marginal cost and average total
Objectives cost.
• Graph average total cost, average variable
cost, average fixed cost, and marginal
cost.
• Understand how firms use the long-run
average cost curve in their planning.
Costs and business
decisions in the café
industry
• In the example of a café, as the
number of tables, chairs, cash
registers, and so on remain fixed in
the short run, (in economics we
would say that capital is fixed), each
successive employee hired (or extra
hour worked) beyond a certain
number will result in a lower
increase in output than the one
before.
Technology: An
economic definition

• Technology: The processes a firm uses to

turn inputs into outputs of goods and
services.
• Technological change: A change in the
ability of a firm to produce output with a
given quantity of inputs.
The short run and the long run in economics

• Short run: The period of time during which at least one of the
firm’s inputs is fixed.

• Long run: A period of time long enough to allow a firm to vary all
of its inputs, to adopt new technology, and to increase or decrease
the size of its physical plant.
 The cost of producing any level of output depends on the
amount of input used and the price the firm must or willing to
pay for them.

There are fixed factors e.g., lands or buildings and variable

factors e.g., labour to determine firms output production.

Short Run In the short run, firms can increase output by using more variable factors. E.g., if a
cruise line wanted to carry more passengers in response to a rise in demand, it could
accommodate more passengers on existing sailings if there is space. But in the short

costs run, it could not buy more ships: there would not be time for them to be built.

In the long run, firms have enough time for all inputs to be
varied. Given long enough, a firm can build a second factory and
install in machines .

Production in the short run is subject to diminishing returns. It says: when one or
more factors are held fixed, there will come a point beyond which the extra output
from additional units of the variable factor will diminish.
Costs and output
• A firm’s costs of production will depend on its output.
• The more it produces, the more factors it must use.
• The more factors it uses, the greater its costs will be.
• The productivity of the factors – the greater their
productivity, the smaller will be the number of them that is
needed to produce a given level of output, and hence the
lower the cost of that output
• The price of the factors – the higher the price, the higher
will be the costs of production.
 • Total cost: The cost of all the inputs a firm uses
The in production.
• Variable costs: Costs which change as the
difference quantity of output changes.

between fixed • Fixed costs: Costs which remain constant as

the quantity of output changes.
costs and • Total Cost = Fixed Cost + Variable Cost
• TC = FC + VC
variable costs
In class video: https://www.youtube.com/watch?v=rYvzM_tayY4;
The Law (or Principle) Of Diminishing Marginal Returns (or Productivity) Explained in One Minute - YouTube
 • Opportunity cost: The highest-valued
alternative that must be given up to engage in
Implicit costs an activity.
• Explicit cost: A cost that involves spending
versus explicit money.
• Implicit cost: A non-monetary opportunity
costs cost.
 • Production function: The relationship
The production between the inputs employed by the
firm and the maximum output it can
function produce with those inputs.
 Short-run production and cost at Julie
Johnson’s photocopying store: Table 6.2
A first look at the
relationship
between • Average total cost: Total cost divided
by the quantity of output produced.
production and
cost
Graphing total cost and average total cost
at Julie Johnson’s photocopying store:
Figure 6.1
The marginal product of labour and the average
product of labour

• Marginal product of labour: The additional output a firm produces as a

result of hiring one more worker.

• Law of diminishing returns: The principle that, at some point, adding more
of a variable input, such as labour, to the same amount of a fixed input,
such as capital, will cause the marginal product of the variable input to
decline.
The marginal product of labour at Julie Johnson’s
photocopying store: Table 6.3
The relationship between marginal and
average product
Average product of labour: The total output
produced by a firm divided by the quantity of workers.

733.3 = (625 + 700 + 875) / 3

Average Marginal Marginal Marginal
product of product of product of product of
labour for labour of labour of labour of
three workers first worker second third
worker worker
Total output, the
marginal product of
labour, and the average
product of labour: Figure
6.2
The relationship between short-run
production and short-run cost
Marginal cost: The change in a firm’s total cost from producing one
more unit of a good or service.

MC =  TC
Q
Graphing cost curves (1 of 2)
▪ Average fixed cost: Fixed cost divided by the quantity of
output produced.
▪ Average variable cost: Variable cost divided by the
quantity of output produced.

Average total cost = ATC = TC/Q

Average fixed cost = AFC = FC/Q
Average variable cost = AVC = VC/Q

ATC = AFC + AVC

Graphing cost curves (2 of 2)
Relationships between MC, ATC, AVC, and AFC

▪ The MC, ATC, and AVC curves are all U-shaped, and the
marginal cost curve intersects the average variable cost
and average total cost curves at their minimum points.

▪ As output increases, AFC gets smaller and smaller.

▪ As output increases, the difference between average total

cost, and average variable cost decreases.
Costs at Julie Johnson’s photocopying store:
Figure 6.3
Long run costs

• In the long run, all factors of production are variable.

• There is time for the firm to build a new factory, to install new machines, to use different
techniques of production
• Firms can combine all its inputs in whatever proportion and whatever quantities it
chooses.
• In the long run, firms will have to make a number of decisions about the scale of its
operations and the techniques of production it will use. In this case, firms can distinguish
three possible situations:
• Constant return to scale – this is where a given percentage increase in inputs will lead to
the same percentage increase in output.
• Increasing return to scale – this is where a given percentage increase in inputs will lead to
a larger percentage increase in output.
• Decreasing return to scale – this is where a given percentage increase in inputs will lead to
a smaller percentage increase in output.
 Returns to scale
Costs in the ▪ Long-run average cost curve: A curve
long run (1 of showing the lowest cost at which the firm is
able to produce a given quantity of output
2) in the long run, when no inputs are fixed.

▪ Economies of scale: Economies of scale

exist when a firm’s long-run average costs
fall as it increases its scale of production
and the quantity of output it produces.
 ▪ Constant returns to scale: Exist when a firm’s
long-run average costs remain unchanged as it
Costs in the increases its scale of production and the
quantity of output it produces.
long run (2 of ▪ Minimum efficient scale: The level of output at
2) which all economies of scale have been
exhausted. It is the minimum point on the long-
run average cost curve.
▪ Diseconomies of scale: Exist when a firm’s long-
run average costs rise as it increases its scale of
production and the quantity of output it
produces.
The relationship
between short-
run average total
cost and long-run
average cost :
Figure 6.5
Conclusions

• Discuss the relationship between a firm’s technology, production and costs.

• Examine the important relationship between a firm’s level of production

and costs.

• To decide the optimal level of production based on a firm’s cost

information.
In-Class
Exercises
 In-Class Exercise 1:
Q1. The table shows how a firm’s output varies with labour
input, all other inputs fixed. Labour costs $500 a unit. The Labour input Output
fixed inputs cost $1500. (units)
(a) Derive a table showing for each output level given above:
1 6
(i) average fixed cost
(ii) average variable cost
2 16
(iii) average total cost
(iv) marginal cost.
3 29
(b) Plot the AFC, AVC, ATC and MC schedules. (Note: Plot the marginal
cost figures at the midpoint of the output range to which they refer.)
4 44
(c) Comment on and explain the shape of the AVC curve and ATC curve.
(d) Comment on and explain the relation between the MC and ATC
5 55
curves.
6 60
7 62
In-Class Exercise 2:

Q2. The table shows the following relationship between hours

spent fishing and the quantity of fish caught for Juan, a Labour (hours)
Quantity of Fish Marginal Product
commercial fisherman. (metrics) (metrics)

a. Complete the Marginal Product column

b. Characterise the production function, that is, does the 1 10
production function display increasing marginal returns,
diminishing marginal returns, etc. 2 18
c. Using the data above, graph Juan’s marginal product curve.
Be sure to label the horizontal and vertical axes. Is your graph 3 24

consistent with your answer to part (b)? Explain.

4 28
d. Juan uses the following inputs for fishing—a small wooden
boat (B), a fishing pole (P) and of course, his labour (L). 5 30
Treating the boat and the fishing pole as fixed inputs and using
the data above, graph Juan’s Total Product of labour curve. Be 6 32
sure to label the horizontal and vertical axes.
In-Class Exercise 3:
Q3. Cost and Revenue of Good X. Quantity Marginal Average Cost ($)
Revenue
Referring the table, answer the following ($)
questions, construct a column of total 0 Not Not Available
cost and marginal cost. (Hint: First, Available
𝑇𝐶
calculate the total cost. Recall 𝐴𝐶 = . 1 8 9
𝑄
To find total cost, 𝑇𝐶 = 𝐴𝐶 × 𝑄. Then, 2 8 5
calculate 𝑀𝐶 =
∆𝑇𝐶
) . Fixed cost is 3 8 3.67
∆𝑂𝑢𝑡𝑝𝑢𝑡 4 8 3.25
$5. 5 8 3.8
6 8 4.5
7 8 5.29